Can't Stop Won't Stop

Last week was an eventful one, to say the least. Both the Fed and the Bank of England (BoE) raised interest rates by a quarter of a percentage point. The former reckons the US banking system is sound and resilient, and remains focused on bringing inflation down to its 2% goal. The BoE, meanwhile, has a long battle ahead after new data out last week showed UK inflation unexpectedly accelerated in February for the first time in four months. That means Britain is the only G7 nation with inflation still stuck in double digits.

Elsewhere, last week saw a dramatic end to Credit Suisse’s woes, with rival UBS agreeing to buy the troubled bank in a government-brokered deal that valued Credit Suisse at $3.2 billion. But as part of the rescue deal, $17 billion worth of Credit Suisse’s additional tier one (AT1) bonds, a type of bank debt designed to take losses during a crisis, was written down to zero. That sparked concern about similar debt and led to further turmoil in the European banking sector at the start of last week, leaving the sector’s valuation near levels last seen during major crises. Finally, liquidity is deteriorating in the world’s biggest and most important bond market, and that has big implications for the global financial system. Find out more in this week’s review.

Macro

As expected, the Fed raised interest rates by a quarter of a percentage point last Wednesday, taking its key federal funds rate to a range of 4.75%-5% – the highest since August 2007. That came as a relief to some investors considering that Fed chair Jerome Powell had earlier this month opened the door to reaccelerating the pace of rate hikes back to half-point increases – but three US bank failures since then unsurprisingly upended those plans. Equally, the rate decision probably disappointed other investors who were hoping for the Fed to pause or even cut interest rates on the back of the recent turmoil in the banking sector.

To be fair to the Fed, there were no easy options this time round. On one hand, a pause could’ve signaled that it’s not confident in the resiliency of the banking system or the economy. On top of that, a pause would prematurely end the Fed’s battle against inflation, which is still three times higher than the central bank’s 2% target. Trouble is, above-target inflation has a tendency to remain stubbornly high, and the Fed’s well-aware of the history of the 1970s when insufficient rate hikes helped to entrench outsized price gains. On the other hand, a hike could add to the stress facing the banking sector and lead to more market volatility in the future. In an extreme scenario, the banking sector’s woes could spiral into a credit crunch that triggers a deep recession.

So, needless to say, the Fed has a tough job ahead as it treads a fine line between combating inflation and preventing an all-out banking crisis. Its latest "dot plot", released alongside its rate decision, shows Fed officials still project interest rates to end 2023 at 5.1% – similar to what they were forecasting back in December. But traders aren’t buying it, with interest rate futures suggesting that the federal funds rate will drop to around 4.2% in December. Put differently, traders are essentially betting that turmoil in the banking sector will push the Fed to cut interest rates this year.

A day later, the Bank of England (BoE) also raised its key interest rate by 25 basis points to 4.25% – its highest level since 2008. That didn’t come as much of a surprise, especially considering that data out a day earlier showed UK inflation unexpectedly accelerated in February for the first time in four months. Consumer prices rose by 10.4% in February from a year ago – a marked acceleration from January’s 10.1% gain and well above the 9.9% forecast by the BoE and economists. On a month-on-month basis, consumer prices were up 1.1% – nearly double the 0.6% increase forecast by economists. The main culprits were food and drink prices, which rose at their fastest annual pace in 45 years. But even core inflation, which strips out volatile food, energy, alcohol, and tobacco prices, rose sharply to 6.2% in February – up from 5.8% the previous month and defying economists’ expectations of a slowdown to 5.7%.

Bonds

The chart below shows the bid-ask spreads of Treasury bonds across various maturities and how they’ve been tending over time. As a quick recap, bid-ask spreads are a commonly used measure of an asset’s liquidity (the ease with which the asset can be converted into cash with minimal costs and without affecting its market price). And earlier this month, bid-ask spreads on two-, 10-, and 30-year Treasuries jumped to their highest levels in at least six months, according to data compiled by Bloomberg.

The jump in spreads happened during one of the wildest weeks for bond markets since at least 2008 after three bank failures caused traders to swing back and forth between betting on Fed hikes and cuts. The Treasury market’s “fear gauge” – ICE’s MOVE index of implied volatility – spiked to levels not seen since the start of the global financial crisis 15 years ago. It’s hard to say what’s causing what, and the two are likely affecting each other. That is, a volatile bond market increases market makers’ risk and pushes them to increase their bid-ask spreads. Those wider spreads, in turn, lead to deteriorating liquidity, which exacerbates price swings and increases market volatility.

This constant loop of diminishing liquidity and increasing volatility matters because Treasuries are vitally important to the financial system: they’re not just the ultimate “risk-free” asset, they also act as collateral for loans and are used to price almost all financial instruments. It’s essential, then, that they remain well-behaved. So when volatility spikes in the Treasury market, it pushes investors and companies to take fewer risks as well as reduces the amount of money in the financial system available for investors to access. And that sends ripple effects across the economy and other asset classes…

Stocks

Credit Suisse has been at the forefront of the banking industry’s drama. Clients pulled more than $100 billion of assets in the final quarter of last year as concerns mounted about its financial health, and the outflows continued even after it tapped shareholders in a 4 billion-franc capital raise. Even a liquidity backstop by the Swiss central bank earlier this month failed to end the market’s worries.

So after a tumultuous couple of weeks, things finally reached a dramatic end: UBS agreed to buy Credit Suisse last Sunday (19-March) in a government-brokered deal aimed at containing the crisis of confidence that was fast spreading across global financial markets. UBS is paying 3 billion francs ($3.2 billion) for its rival, with Credit Suisse’s shareholders receiving 1 UBS share for every 22.48 Credit Suisse shares that they hold. That values Credit Suisse at 0.76 francs a share – far below its closing price of 1.86 francs the Friday before the deal was announced. The offer also marks a 99% decline in Credit Suisse’s value per share from its peak in 2007.

The all-share deal also includes extensive government guarantees and liquidity provisions. The Swiss National Bank, for example, is offering 100 billion francs in liquidity assistance to UBS while the government is granting a 9 billion franc guarantee for potential losses from the assets UBS is taking over. But here’s where things got a bit ugly: Swiss regulator Finma said that 16 billion francs ($17 billion) of Credit Suisse’s additional tier one (AT1) bonds, a type of bank debt designed to take losses during a crisis, will be written down to zero as part of the rescue deal with UBS.

The bond wipeout is the biggest loss yet for Europe’s $275 billion AT1 market and meant that Credit Suisse’s bondholders lost more than its shareholders, casting doubt on the hierarchy of claims in the event of a banking failure. That naturally sparked concern about similar debt and led to further turmoil in the banking sector (especially in Europe) at the start of last week.

But for brave stock investors, there is one silver lining to this month’s selloff: European banks’ valuations are starting to look very cheap, with the sector’s forward P/E hovering near levels last seen during major crises. Analysts bullish on the sector point to a few factors that can potentially cause bank valuations to re-rate higher. First, UBS’s acquisition of Credit Suisse removes a years-long overhang for Europe’s banking industry. Second, after being crushed by years of negative interest rates, European banks are starting to see their profits expand as rates and bond yields rise. Third, at around 7.6%, the sector offers the highest dividend yield in Europe. But whether the sector’s bulls end up being correct depends on a few things – the future direction of interest rates, how severe a potential recession turns out to be, and whether contagion fears spread to other lenders, to name a few.

This week

• Monday: German business climate index (March). 
• Tuesday: French business climate index (March), US consumer confidence (March). Earnings: Micron Technology.
• Wednesday: Nothing major.
• Thursday: Eurozone economic sentiment (March), German and Spanish inflation (March), Japanese trade balance (February).
• Friday: Eurozone inflation (March) and unemployment (February), Japanese inflation (March) as well as unemployment (February) and retail sales (February), Chinese PMIs (March).